For several years now, banks in the United States and in most developed nations have provided interest rate risk management products to their customers in the form of privately negotiated contracts commonly referred to as over the counter derivatives. These contracts have allowed both corporations and individuals to transfer unwanted risk exposure to changes in the general level of interest rates from themselves to their banks. By helping corporations and individuals manage their exposure to fluctuating interest rates, these derivatives have greatly improved the ability of global capital markets to distribute capital more efficiently and at reduced cost to both borrower and lender.
Banks are able to offer these products to their customers due to the fact that a variety of financial instruments have been developed which provide protection for the banks while they act as a conduit for the transfer of risk. Ultimately, the banks attempt to pass on the risk that they received from one customer, to another customer who can benefit from it. However, the financial instruments used to transfer the risk are limited in their ability to immunize banks from certain kinds of risks that they have accepted from their customers. As the world witnessed during the fall of 1998, interest rate markets can be very volatile and banks can still be very vulnerable to losses.
To fully understand the deficiencies in existing computer systems that provide support to futures exchanges where many of the financial instruments trade, a short explanation of the development and structure of those financial products is provided. In a typical interest rate derivative transaction, a bank will assume the interest rate exposure that a particular customer wishes to transfer, and the bank will collect a fee for this service. The ultimate goal of the bank is to intermediate between two customers with opposite needs. For example, the bank would like to find one customer who needs protection from rising interest rates and another customer who needs protection from declining interest rates. After the bank has assumed the exposure of one customer, but before it has had the opportunity to find the second customer with a need for the exposure, the bank will attempt to mitigate the risk associated with this exposure by utilizing one or more instruments that are available in the financial markets. These are referred to as hedge instruments.
Hedge instruments typically include: United States Treasury bonds and notes; futures contracts on these bonds and notes (traded at The Chicago Board of Trade), and Eurodollar futures contracts (traded at the Chicago Mercantile Exchange). While far from being a perfect hedge, these instruments have proven themselves capable of providing some interim protection from various interest rate risk exposures while the bank seeks to identify a customer who would benefit from said exposure. Once the second customer is identified, the bank will attempt to transfer the exposure to the second customer. If the second customer is agreeable, the bank will then transfer the risk and remove the temporary hedge that it had put on in the form of a purchase (or sale) of notes, bonds, or futures. The bank is then left with two interest rate derivative contracts, providing it with offsetting exposures to movements in interest rates. In effect, the bank has inter mediated between two of its customers, provided each with valuable risk management, and taken a fee for its efforts.
The following discussion is focused on the instruments available in the financial markets today for use by the banks for temporary or interim hedging. Each of the currently available instruments has certain advantages and disadvantages. The following evaluation of these instruments is based on two criteria: cost and utility.
Eurodollar futures provide a somewhat effective hedge due to the fact that their price responds to changes in LIBOR interest rates, and most interest rate derivatives are designed to transfer LIBOR risk from one entity to another. LIBOR is an acronym for London Interbank Offered Rate, a benchmark rate published in London every business day, and the most commonly used rate in commercial lending to price floating rate loans. Eurodollar futures provide a very cost effective hedge for a bank during the period that a bank seeks to permanently offset their exposure with either another customer or another bank. In addition to being sensitive to changes in LIBOR interest rates, Eurodollar futures have another very valuable design feature. They are designed to cover a period of only three months each, so that a bank can construct a hedge to match the term of its derivative contract. For example, if a bank enters into a derivative contract for a period of thirty months, the bank could buy (or sell) a string of ten Eurodollar futures, starting today and ending thirty months from today, with each contract covering a period of three months. This feature means that Eurodollars futures afford banks the most flexibility when hedging their interest rate risk.
The next kind of instruments includes United States Treasury (Treasury) bonds and notes. These two instruments are identical with the exception of time to maturity. Notes mature in ten years or less while bonds mature in ten years or more. For purposes of this discussion we will use the term “t-notes” to refer to both instruments. The primary advantage of t-notes for use as a hedge is that they do possess convexity very similar to the convexity exhibited by interest rate derivatives. Therefore, a bank utilizing t-notes to hedge its interest rate exposure would not be required to adjust the quantity of t-notes it had bought or sold as interest rates fluctuate from day to day. The primary drawback to t-notes for use as a hedge is that their price responds to changes in treasury interest rates rather than LIBOR interest rates. This is a major problem since the correlation between LIBOR interest rates and treasury interest rates is historically very low. In other words, LIBOR rates can change, affecting the value of the derivative, while treasury rates remain unchanged and therefore the value of the hedge remains unchanged. T-notes are commonly utilized to hedge interest rate derivatives which mature in three years or more, despite the fact that their use leaves a bank exposed to changes in the relationship between LIBOR interest rates and treasury interest rates. The other major problem with the use of t-notes to hedge interest rate derivatives is their lack of flexibility, Typically, there are just four t-notes available for use as a hedge. There are t-notes maturing in 2, 5, 10, and 30 years. There are, of course, many other t-notes available, but they are difficult to buy and sell efficiently. The four t-notes mentioned above are known as the “on the run” notes and the vast majority of the buying and selling in t-notes involves these four issues.
The third instrument, or group of instruments, is futures contracts on t-notes. These also are traded at the Chicago Board of Trade. The use of these contracts to hedge interest rate exposure is very limited due to the fact that these instruments possess the same disadvantages as t-notes but also possess an additional feature known as basis risk. The term “basis risk” refers to the fact that the value of these contracts is based on a formula which causes these contracts to have a very strong relationship with a specific t-note issued by the United States Treasury, and then to switch from time to time to a different specific t-note. This basis risk, along with the drawbacks that these instruments share with t-notes, causes them to be used very rarely by banks as a hedge for interest rate derivatives.
In addition to the hedge instruments in existence and in use for U.S. dollar denominated interest rate derivatives, their are two other hedge instruments available; one for Australian dollar denominated derivatives and one for Deutsche mark denominated derivatives. These are described because they are considered to be prior art.
The London International Financial Futures and Options Exchange (LIFFE) currently offers a product which it calls the Libor Financed Bond. This product was created by the LIFFE in an attempt to provide a hedge for Deutsche mark denominated, LIBOR based, interest rate derivatives. The Libor Financed Bond exhibits the convexity of an interest rate derivative, like t-notes, while at the same time providing price sensitivity to LIBOR interest rates. The Libor Financed Bond does not, however, provide the banks with the flexibility that Eurodollar futures do. The contract covers an interest period of either five years or ten years, compared to the three month period that the Eurodollar futures cover. The result is that the contract precludes banks from an optimal hedging of their interest rate exposure.
The other known prior art includes the Commonwealth Treasury Bond Future which is listed and traded at the Sydney Futures. Exchange (SFE) in Australia. This futures contract is designed to be sensitive to changes in the yield on ten year and three year Australian Government Bonds. The contract price is equal to 100 minus the yield on a hypothetical ten year and three year bond. The tick value of this contract varies with the yield of the bond, and the tick values are prescribed in a table published by the SFE. It is this variable tick value which confers upon the contract the convexity which the actual Australian Government Bonds possess. So these contracts posses convexity, which is the inventor herein believes to be desirable, but they are not sensitive to LIBOR interest rates and they do not provide the flexibility that shorter contracts like three month Eurodollar futures contracts do.